'The fox knows many things…'

The Disposition Effect – Why it Matters

Sadly, the long-term performance of most individual investors is poor. What’s even sadder is that, in many cases, we only have ourselves to blame. We are all prone to behavioral biases that affect our judgment. That’s the bad news. The good news is that we can significantly improve our results by sticking to an investment strategy that helps us to reduce the number of costly mistakes that we make.

But first we need to identify our mistakes. Academics Brad Barber and Terrance Odean[1] describe the errors that individual investors commonly make…

They trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many hold poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk, and many are unduly influenced by media and past experience.

Some of these errors are more subtle than others. For example, it may not be immediately obvious that selling shares that have increased in value since bought (winners) and holding shares that have decreased in value since bought (losers) is a bad idea. After all, it’s commonly said that nobody ever went broke taking a profit. But is this always true?

Here’s two reasons why being quick to sell and take a profit may not be such a good idea. First, truly great companies are hard to find. Just how rare are they? You may be surprised by the answer. A long-term study[2] (1983 – 2007) of the largest 3000 stocks listed in the United States found that:

39% of stocks had a negative lifetime total return (2 out of every 5 stocks are a money losing investment)

5% of stocks lost at least 75% of their value (Nearly 1 out of every 5 stocks is a really bad investment)

64% of stocks under-performed the Russell 3000 during their lifetime (Most stocks can’t keep up with a diversified index)

In other words, most of the stock market’s performance can be attributed to the performance a handful of truly excellent companies that have been able to grow over time by re-investing retained earnings in profitable business opportunities.

So what’s the lesson? Great investments are hard to find. If you’re lucky enough to own one of these companies then you should really think twice (maybe even three times) before selling.

The best way to illustrate this is with an example. In his 1995 letter to Berkshire Hathaway shareholders, Warren Buffett wrote about an investment in Disney…

I first became interested in Disney in 1966, when its market valuation was less than $90 million, even though the company had earned around $21 million pre tax in 1965 and was sitting with more cash than debt… Duly impressed the Buffett Partnership Ltd. bought a significant amount of Disney stock at a split-adjusted price of 31 cents a share. That decision may appear brilliant, given that the stock now sells for $66. But your Chairman was up to the task of nullifying it: in 1967 I sold out at 48 cents.

Buffett had found an excellent company in Disney; but he took a quick 55% profit only to miss out on a 21,290% gain (not counting dividends)[3].

Second, selling winners is tax inefficient. Selling a winning stock triggers a capital gain. For tax purposes, investors should postpone paying tax by continuing to hold their profitable investments. Instead, they should capture tax losses by selling their losing investments.

Taxes severely reduce the benefits of compound growth over time. Assuming that we’ve invested in a company that can reinvest in profitable business opportunities, we’ll be much better off delaying the paying of tax by remaining invested; assuming that the company is able to grow its over time by re-investing retained earnings into profitable business opportunities.

Just how severe is the impact of taxes over the long-term? Let’s consider two hypothetical investors: Betty and Boris. Betty invests $10,000 in the shares a company that is able to grow the book value of its equity by 10% per year by reinvesting in profitable business opportunities. She holds that investment for 30 years. At the end of 30 years Betty sells her investment. Her marginal tax rate is 37%.

Boris also invests $10,000 but instead he buys and sells a different share each year for a 10% profit. Boris repeats this for 30 years. Let’s assume that he has a 100% success rate in picking winners. His marginal tax rate is also 37%.

Who wins after 25 years? Betty’s initial investment is now worth $99,022.40 after tax. Meanwhile Boris has only made $62,516.97, that’s almost 60% lessafter tax, despite an unbroken record of perfect stock-picking lasting 30 years!

What about holding onto losers? Many investors reason that it’s only a “paper loss” if you don’t sell, as opposed to a realized loss if you do. Besides, there’s always a chance that the stock’s value might recover.

This faulty reasoning ignores the mathematics of loss illustrated in the table below. Here’s how to read the table: to break even after a 25% loss, an investor requires a 33% gain (highlighted in red), or a gain that is 1.33 times the size of the loss. If we assume that the loser goes on to perform in-line with the long-term average for Australian shares (from 1987 through to 2016) then it would take 3.17 years to break even.

The negative effects spiral rapidly out of control once a loss exceeds -25%. For example, an investor holding a stock that has lost 70% of its value requires a gain of 233% just to break even – that’s over 22 years worth of share market gains!

Loss

Gain

Multiple

Years

-5%

5.3%

1.05

0.50

-10%

11.1%

1.11

1.06

-15%

17.6%

1.18

1.68

-20%

25.0%

1.25

2.38

-25%

33.3%

1.33

3.17

-30%

42.9%

1.43

4.08

-35%

53.8%

1.54

5.13

-40%

66.7%

1.67

6.35

-45%

81.8%

1.82

7.79

-50%

100.0%

2.00

9.52

-55%

122.2%

2.22

11.64

-60%

150.0%

2.50

14.29

-65%

185.7%

2.86

17.69

-70%

233.3%

3.33

22.22

-75%

300.0%

4.00

28.57

-80%

400.0%

5.00

38.10

-85%

566.7%

6.67

53.97

-90%

900.0%

10.00

85.71

-95%

1900.0%

20.00

180.95

The mathematics of loss highlights the need to deal with losses before they get out of control. Why is this so hard to do? The tendency to sell winners and to hold onto losers is deeply ingrained in investor psychology. For example, the stockbroker Gerald M Loeb wrote in 1935[4]:

Cutting losses is the one and only rule of the markets that can be taught with the assurance that it is always the correct thing to do… But, as a matter of actual application, it requires a completeness of detachment from human frailties which is very rarely achieved. People like to take profits and don’t like to take losses. They also hate to repurchase something at a price higher than they sold it. Human likes and dislikes will wreck any investment program. Only logic, reason, information, and experience can be listened to if failure is to be avoided.

Academics refer to the tendency to sell winners and hold losers as the “Disposition Effect”. The name comes from the title of an academic paper written by professors Hersh Shefrin and Meir Statman in 1985 entitled The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence [5]:. In it, the authors identify 4 possible explanations for the disposition effect, they are:

Prospect theory (for more information please see my earlier post)– Developed by Daniel Kahneman and Amos Tversky, prospect theory predicts that the pain of loss is felt roughly twice as strongly as the joy associated with a gain. The theory also predicts that we focus on our change in wealth, relative to a fixed reference point (e.g. the price at which the purchased a share), rather than our overall level of wealth. It also predicts that we often take less risk when trying to protect a gain (e.g. by investing in “sure things”) and more risk when trying to avoid a loss (e.g. by “doubling down”).

We can see how prospect theory predicts that investors will be disposed to selling winners and holding losers by considering two examples.

Andrew purchased a stock one month ago for $50 and who finds that the stock is now selling at $40. He must now decide whether to realize the loss or hold the stock for a further month. Let’s assume that there’s a 50:50 chance that the stock will increase in price by $10 or decrease in price by $10.

Andrew can:

Sell the stock now; thereby realizing what had been a $10 paper loss.

Hold the stock for one more month, given the 50:50 odds between losing $10 and breaking even.

Which option do you think Andrew would choose?

The majority of people think that Andrew will choose option B, even though mathematically the two choices are identical: (50% × $30) + (50% × $50) = $40. In fact, option A is better if you factor in the effect of taxes.

Conversely, Amy purchased a stock one month ago for $50 and who finds that the stock is now selling at $60. She must now decide whether to realize the gain or hold the stock for a further month. Amy can:

Sell the stock now, thereby realizing what had been a $10 paper gain.

Hold the stock for one more month, given the 50:50 odds between making an additional $10 and losing $10

Which option do you think Amy will choose?

The majority of people think that Amy will choose option A, even though mathematically the two choices are identical: (50% × $70) + (50% × $50) = $60. Option B is better because Amy will avoid paying taxes.

Regret aversion – The scenarios above also serve as examples of regret aversion. For Andrew, selling at a loss (even though the after-tax return is higher) means admitting that he was wrong. Meanwhile, holding the stock allows him to avoid the regret that comes with making a mistake.

In Amy’s case, holding onto the stock means risking the profit she’s already made. If the stock falls back to $50, she’ll kick herself for not taking a $10 profit when she had the chance. Meanwhile, taking the $10 profit creates the feeling of pride, even though it lowers Amy’s after-tax return.

Mental accounting – We open a new mental “account” each time we purchase an investment. We then focus on the performance of each account, rather that the performance of our portfolio as a whole. This is known as narrow framing. Shefrin and Statman suggest that selling a losing stock is hard to do because we perceive this as closing our mental account at a loss.

Self-control issues – The rational part of us may know that selling winners and holding onto losers is the wrong thing to do and yet we often struggle to take action. In other words, we don’t have enough self control to sell our losers. We also find it hard to resist the instant gratification that comes from selling a winner.

Just how large an impact does the disposition effect have on investor behavior? Terrance Odean (1998) examined the trading records of 10,000 individual accounts from one of the largest US discount brokerage over the period from 1987-1993. He found that 60% of all sales were winners, while 40% were losers. In other words, investors realized their gains at a 50% higher rate than their losses. The larger the gain or loss, the stronger tendency to sell winners and hold losers.

Research into the behavior of individual investors in other countries has yielded similar results. “The disposition effect is remarkably consistent and robust phenomenon.”[6]

It’s unlikely that we will be able to completely avoid the disposition effect. Even professional investors are prone to selling their winners and letting their losers ride, although they do appear to be less prone to the disposition effect than individual investors. This suggests that it is possible to learn how to manage its influence on our decision-making.

We’ll consider techniques that can help investors manage the disposition effect in my next blog post.